Importance of iron ore futures
A futures contract in commodities is an agreement to buy or sell a particular amount of a commodity at a fixed price on or before a certain date. These types of contracts reflect market sentiment and expectations regarding future supply, demand, and prices for a particular commodity.
As we discussed in the previous parts of this series, Chinese steel capacity cuts have subdued the demand for iron ore in the near term. Most market participants think after the cuts are lifted in mid-March in 2018, pent-up demand could cause a surge in iron ore prices. This situation is also visible in the forward curve at the Dalian Commodity Exchange (or DCE). The May 2018 contracts are costlier than the January 2018 contracts. This situation, where futures contracts trade above spot prices, is known as “contango.” The futures curve, in this case, begins to slope upwards. The market condition opposite to contango is known as “backwardation.”
The iron ore futures market has been characterized by backwardation for a long time now. The market had been constantly expecting lower futures prices due to ever-increasing supply and weaker to flat demand scenario. Now, however, the market is expecting steel mills to replenish their inventories after March 2018, which could lead to higher iron ore prices. According to an article by Bloomberg, Fortescue Metals Group’s (FSUGY) CEO, Nev Power, says, “The forward curve has gone into contango for the first time in a very, very long time.” Power believes this trend is due to pent-up demand that will come online after winter.
The most likely question on investors’ mind might be whether the contango is here to stay. And the answer lies in the actual capacity cuts taking place in the Chinese markets, which would drive the extent of pent-up demand after the cuts go offline. If the demand actually increases after winter, the stock prices for miners (XME) such as Cleveland-Cliffs (CLF), Rio Tinto (RIO), Vale (VALE), and BHP (BHP) could remain supported.